Infinite Banking vs RRSP and TFSA: A Canadian Tax Comparison

Introduction

Anyone presented with an infinite banking proposal hears a version of the same comparison. Registered plans are limited, restrictive and eventually taxable, while a participating whole life policy accumulates without annual tax and can be accessed at any time.

Parts of that comparison are accurate. Other parts leave out the features that matter most for the decision.

The question deserves a direct answer, and the direct answer is that for most Canadians registered plans should be used first. Understanding why requires looking at what each structure actually does rather than at how each is presented.

How Each Treats Contributions

The three structures differ at the point money goes in.

An RRSP contribution is deductible. The contributor reduces taxable income in the year of contribution, which means the government effectively funds part of the deposit at the contributor’s marginal rate.

A TFSA contribution is made with after-tax dollars. There is no deduction.

A life insurance premium is also made with after-tax dollars, and it is not deductible. More than that, part of each premium is consumed by the cost of insurance and the insurer’s expenses rather than accumulating at all.

So at the contribution stage, the RRSP has a clear advantage, the TFSA is neutral, and the policy starts behind because not every dollar contributed becomes an accumulating dollar.

How Each Treats Growth

This is where the policy argument is strongest, and it is a fair point.

Growth inside an RRSP is not taxed annually. Growth inside a TFSA is not taxed annually. Growth inside a life insurance policy is not taxed annually either, provided the policy stays within the rules that govern how much can accumulate.

All three defer or avoid annual taxation. On this dimension they are broadly comparable, and the policy is not distinctive.

What is distinctive is the cap. Registered plans limit what can be contributed. Policies limit what can accumulate on a tax advantaged basis, through rules that were tightened in 2017 and that reduced longer term accumulation room.

Neither structure is unlimited, and the suggestion that a policy escapes the caps that apply to registered plans is inaccurate.

How Each Treats Withdrawals

The differences at the exit are substantial.

RRSP withdrawals are fully taxable as income, and withdrawals become mandatory once the plan is converted.

TFSA withdrawals are not taxable, are not income tested, and the room is restored in the following year.

Policy access depends entirely on the route. A surrender or withdrawal produces a taxable amount. A policy loan produces a taxable amount, usually smaller. A collateral loan from a bank produces none at the time of borrowing, which is the route the strategy relies on.

The TFSA is therefore the cleanest exit of the three. The policy’s most favourable route requires a bank to participate.

The Features That Actually Differ

Setting the tax treatment aside, the structures differ in ways that often matter more:

• Registered plans carry no insurance cost, while a policy does
• Registered plans require no lender, while the policy’s best access route does
• A policy provides a death benefit that registered plans do not
• Registered plan returns depend on investments the holder chooses
• Policy returns depend on dividends declared annually at the insurer’s discretion

The death benefit is the genuine point of difference and the one worth paying for where it is needed. The rest generally favour the registered plans.

The Cost Nobody Compares

An honest comparison has to account for what the insurance costs.

A policy is not an investment account with a tax feature attached. It is a life insurance contract. The cost of providing the coverage is deducted year after year, and it increases as the insured ages.

Over a long holding period this is a real and compounding drag on accumulation. It is the price of the death benefit, and where the death benefit is needed it is money well spent.

Where the death benefit is not needed, the purchaser is paying for coverage they did not want in order to obtain a tax feature that registered plans provide without that cost.

This is the central weakness in most infinite banking proposals made to people who have unused registered room.

Guarantees and Flexibility

The comparison runs the other way in one respect.

A participating whole life policy provides a contractual schedule of guaranteed values. A registered portfolio provides no floor, and a holder who needs funds after a market decline withdraws at the reduced value.

Against that, registered plans are far more flexible. Contributions can be paused, resumed, reduced or stopped, and the funds can be reallocated.

A policy generally requires premiums to be maintained, and an owner who stops funding in the early years will find the accumulated value well below what was contributed.

The policy trades flexibility for a floor. Whether that trade is worthwhile depends heavily on the owner’s circumstances and discipline.

The Order That Usually Makes Sense

For most people the sequence is not difficult to establish.

Any employer matching should be captured first, since it is an immediate return nothing else matches.

TFSA room generally comes next, because contributions grow and come out without tax and without affecting income tested benefits.

RRSP room is usually next, and is more valuable the higher the contributor’s current marginal rate relative to their expected rate in retirement.

A permanent policy belongs after those, and only where there is a genuine insurance need independent of the accumulation feature.

The proposals that fail are the ones that reverse this order, placing a policy ahead of unused registered room.

Where the Policy Genuinely Fits

There are real situations where the comparison favours the policy.

Someone who has exhausted registered room and still has surplus cash flow has a genuine question about where the next dollar goes, and a policy is a legitimate answer.

Someone with a permanent insurance need, which most business owners and anyone with a liability crystallizing at death will have, is buying something registered plans cannot provide.

Someone whose estate plan requires funds at death in a known amount is better served by a contract that guarantees that amount than by a portfolio that might not.

In each of those cases the policy is doing work the registered plans cannot do. That is the correct basis for the decision.

Common Planning Mistakes

Several errors recur.

Purchasing a policy while registered room remains unused, on the strength of the tax deferred growth argument.

Comparing a policy illustration against a registered plan projection without accounting for the cost of insurance inside the policy.

Treating illustrated dividend scales as though they were contractual.

Assuming policy access is as straightforward as a TFSA withdrawal, when the most favourable route requires a lender.

Buying for the accumulation feature when the death benefit is the only thing the structure provides that the alternatives do not.

Conclusion

RRSP contributions are deductible, TFSA and life insurance premiums are not, and part of every premium funds insurance rather than accumulation.

All three structures avoid annual taxation on growth, and all three are capped, so the policy is not distinctive on that dimension.

The TFSA offers the cleanest access, RRSP withdrawals are fully taxable, and the policy’s most favourable access route depends on a third party lender rather than on the contract itself.

What a policy provides that the alternatives cannot is a death benefit, together with guaranteed values that a market portfolio does not offer.

For most Canadians the order is employer matching, then TFSA, then RRSP, then a permanent policy where a genuine insurance need exists. A proposal that reverses that order should be examined carefully.

Tax Partners can assist you in structuring your affairs properly and ensuring full compliance while optimizing your tax position.

This article is written for educational purposes.
 

Should you have any inquiries, please do not hesitate to contact us at (905) 836-8755, via email at info@taxpartners.ca, or by visiting our website at www.taxpartners.ca.
 

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